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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/26374
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| Title: | Reconciling the Return Predictability Evidence |
| Authors: | Lettau, Martin
Van Nieuwerburgh, Stijn |
| Issue Date: | 27-Apr-2006 |
| Series/Report no.: | FIN-06-013 |
| Abstract: | Evidence of stock return predictability by financial ratios is still
controversial, as documented by inconsistent results for in-sample and
out-of-sample regressions and by substantial parameter instability. This
paper shows that these seemingly incompatible results can be reconciled
if the assumption of a fixed steady-state mean of the economy is
relaxed. We find strong empirical evidence in support of shifts in the
steady-state and propose simple methods to adjust financial ratios for
such shifts. The in-sample forecasting relationship of adjusted price
ratios and future returns is statistically significant and stable over
time. In real-time,however, changes in the steady-state make the
in-sample return forecast ability hard to exploit out-of-sample. The
uncertainty of estimating the size of steady-state shifts rather than
the estimation of their dates is responsible for the difficulty of
forecasting stock returns in real-time. Our conclusions hold for a
variety of financial ratios and are robust to changes in the econometric
technique used to estimate shifts in the steady-state. |
| URI: | http://hdl.handle.net/2451/26374 |
| Appears in Collections: | Finance Working Papers
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